Production and Inventory Management

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1 Production and Inventory ManagementBefore we get started, let’s take a minute or two to remember where we are. We began the course by discussing the planning management function. Everything we did was focused on deciding what firm’s values were, what consumer need it was going to fill, and finally how it was going to fill that need in a way that would grant it a sustainable competitive advantage.Next we turned our eyes to setting up an organizational structure that would permit the business to efficiently and effectively carryout the firm’s purpose and objective. Now it is time to move to the 3rd business function (controlling) where the feedback mechanisms are developed to measure our progress toward accomplishing those goals set in planning.In the last chapter we reviewed production theory from economics so we will know how to manage our production so we can maximize our long-run profits.Let’s put what we learned in that chapter to work.

2 Production and Inventory ManagementUnderstand Cost RelationshipsEconomic efficiency (profits)Understanding of relationships helps managersEffective production decisionsExperience has shown that business managers who understand the economics underlying production have a better chance of achieving maximum profits (maximum economic efficiency).They are more profitable because they understand the economic relationships that are at work and use that knowledge to their advantage in the form of better decision making. This makes them better able to achieve the financial goals sets in the planning function.Managers are Better Able to Meet Financial Objectives

3 Management Information SystemsMIS providesAccurate and timely productionCost informationAll phases of businessData in proper form neededAccounting information that allow accurate and quick development of business financial documentsEfficiently and effectively monitoring and controlling business production costsThe first step in this process is to have a good accounting system. But this is never enough. Accounting tells you what happened but only after the period ended and usually not in a form that managers can use directly in decision-making. It does not give you information on the current situation nor does it help you make decision about the future.Management information systems (MIS) fill this void by giving accurate and timely information in forms that managers can quickly use to make decisions and control ongoing operations. There is no need to wait until the end of year or month to find out what’s happening.MIS makes it easier to control production processes and costs. The IT revolution has made it feasible for firms of all sizes to have an efficient and effective MIS for nearly everything it does. Many business analysts attribute much of eBay’s success to its MIS that closely monitors just about everything it does and allows it can rapidly adjust to changes in its business environment.

4 Cost Concepts Cost: Acquire good or serviceOpportunity cost: Return (measured by highest value)Implicit cost: Do not include cash paymentsIncluded in calculation of total cost of productAnother source of confusion in this area is what do we mean when we say cost.To some cost means what you give up to acquire something. It can be money, but it can also be time, expertise, or another good.An economist would take this even further to include the thing of highest value that is given up to acquire the product. For example, the real cost of attending college is not just what you are paying for tuition, and room and board. The real cost should also include the income you are passing up each year by attending college. This what you compare to what you will make with your college degree down the road.The next cost concept we will look at here are implicit costs. These are costs that need to be included in the cost calculation even if they do not change because of it.

5 Cost Concepts Controllable and Uncontrollable CostsIncremental, Avoidable, and Sunk CostsTotal Cost = Total Fixed + Total Variable Costs CostsTotal Fixed Cost (TFC)Total Variable Cost (TVC)Total Cost (TC)Now we can move to another view of costs. From this perspective we look at costs in terms of whether they are either controllable or uncontrollable. The separation of costs in this way are just as they sound.Another way to classify costs is determine if they are incremental—they change, avoidable—can be end with a decision, or sunk—can never be recovered.Each of these classifications has a place in cost determination depending on the situation. So when you hear term cost be sure to know which form of costs you are talking about because each conveys a very different meaning.The most useful way to look at cost is to separate them into fixed (costs that to not vary with output) and variable cost (costs that do vary by output level). As you can see total cost of production is the sum of these two cost groups.

6 Contribution = Selling Price/Unit minus Variable Cost/UnitContribution ConceptSelling Price/Unit = Total Cost/Unit + Profit/UnitTotal Cost/Unit = Variable Cost/Unit + Fixed Cost/UnitSelling Price/Unit – Variable Cost/Unit = Fixed Cost/Unit + Profit/UnitContribution = Selling Price/Unit minus Variable Cost/UnitSeparating costs into either fixed and variable costs is pretty simple, but give us is very powerful way to deal with costs. Let’s take a look at one of the things we can do using this approach—the contribution concept.To understand the contribution concept we have to start with the selling price formula where the selling price per unit is equal to the total cost per unit plus the profit per unit. We then break the total figure down to its two to parts—variable and fixed costs per unit, and substitute this into the first equation.The next step is to move the variable cost per unit to the other side of the equals sign so selling price per unit minus variable cost per unit is now equal to fixed cost per unit and profit per unit.Now let’s give the part to the left of the equals sign the title contribution. This is how much is contributed to fixed costs per unit and profit per unit when a unit is sold. This is equal to the selling price per unit minus the variable cost per unit.The contribution per unit is also a powerful tool that we can use in many ways to better manage our production. On the next couple of slides we will see what we can do with it.

7 The Contribution ConceptSelling Price/Unit = $ %Minus: Variable Cost/unit = -$ %Contribution to Fixed Costs = $ %and Profit/UnitWe can use this information to make pricing decisionsOne of the most common uses of the contribution concept is for pricing decisions. Many firms apply a standard formula to price their new products.As you can see on the slide the contribution to fixed costs and profits is $80. If this is the standard for the firm it is often easier to report this as a percentage of the price of a typical unit. Here, for example, the contribution is said to be 40 percent.

8 Applying the Contribution ConceptEstablish Selling Price of New ProductIf contribution/unit is typically 40% of selling price/unit, the proper selling price/unit for a new product would be:Total Variable CostsPer Unit=[1- Contribution MarginPercentage]*[Selling PricePer Unit]To keep things simple, let’s rework this equation assuming we have a new product for sale that has a total variable cost per unit of $120.If the firm typically operates with a 40% contribution it is easy to quickly determine the proper selling price for this item using the formula given on the slide---$200/bag$ = [1 – 0.40] * Selling price per bag$ = Selling price per Bag

9 Shutdown Point Short runShort Run vs Long Run PricingShort runFirm with idle capacity can take job where price does not cover all total costContribution is positive (P- AVC > 0).Contribution is negative (P-AVC < 0) firm is better off to shut down.Long RunAll costs coveredThe contribution concept can also be applied to another important area of production management---Determining the Shutdown Point.The shutdown point is the minimum price a firm can accept for a job and be better off for taking the job rather than refusing the job and shutting down.In the short run, firms with idle capacity should take a job if the contribution is positive---Price/Unit >Variable Cost/ unit. When this happens the firm covers all the variable costs and makes a contribution to total fixed costs. Thus, the loss is smaller than if they refused the job.If the contribution to negative---Price/Unit < Variable cost/unit, the firm does not cover all its variable cost per unit. It ends up losing on the variable cost plus having to pay the fixed cost. It is better off to shutdown because it loses less money.This can be done only in the short run. In the long run you must cover all of your costs.

10 Are we better off to harvest the crop just leave it in the field?Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96A drought has hit the farm and now it is harvest timeWe have $18/acre invested in our cropGoing in to harvest what is left will cost an additional $6/acre (the variable cost) for a total cost $24/acreCrop is expected to yield six bushels per acre and market price is $2/bushelNow let’s take the shutdown decision up one level. Ken Casavant and co-authors in a great introduction to agricultural economics textbook that we use in AG BM 101 use this example to illustrate how knowledge about the combination of sunk costs and the shutdown point lead to better production decisions. These values come from Casavant’s family farm in North Dakota.A severe drought has reduced their crop yields significantly. They estimated that they have already invested $18/acre in their wheat crop. It will cost them another $6/acre to harvest it.They expect to get a yield of 6 bushels/acre that they can sell for $2/bushel.The management decision is are we better off harvesting the crop or just leaving it in the field and starting over next year?Are we better off to harvest the croporjust leave it in the field?

11 Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 The AnswerHarvest the crop!Incremental Revenue > Incremental Cost $12/acre > $6/acreWe will have $6/acre more to reduce the fixed costs than if we don’t harvestThe answer is that we are better off harvesting the crop.We arrived at that answer buy using incremental analysis and knowing the difference between sunk and incremental costs.The only costs that are relevant to the decision are the incremental ones—the ones that change as a result of our decision. All the other costs are sunk costs—they are the same regardless of what we do.Let’s look at the incremental revenues and costs.The incremental revenue per acre is $2 x 6 bushels or $12The incremental cost per acre is $6The farm is $6/acre better off if it harvests the crop. It is not enough to recover the $18 of sunk costs but the losses are smaller.Harvesting is the better choice. Once again, understanding costs helps managers make better decisions!!!In the short run do not worry about the sunk costsLook only at incremental revenue and cost

12 Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 The AnswerIf we do not harvest we lose $18/acre (the sunk costs)If we do harvest we lose $12/acre$18/acre sunk cost + $6/acre harvesting cost = $24/acre total costTotal Revenue: $12/acre (6 bu/acre x $2/bu)Less: Total Cost - $24/acre Loss - $12/acreFor those with some doubts about this decision here is the no harvest alternative's costs so you can compare them.

13 Break-Even AnalysisBreak-Even Analysis helps managers find combination of costs, output, and selling price that permits firm to break-even, no profits and lossesSelling PriceThe best known application of the contribution applications is Break-Even Analysis (BEA). BEA helps managers find the right combination of costs, output, and selling price that will allow the firm to just break-even, no profits or losses.The break-even point helps managers assess their prospects for success in the market, make pricing decisions, and evaluate changes in costs for things such as advertising and plant expansions.The triangle in the slide reminds us of the interrelatedness of the cost, output levels, and selling prices. If we know any two of these we can calculate the missing item.First, we are going to build the break-even equation from the contribution concept and show how to use it to make better production decisions. The section will end with a brief look at the many extensions of break-even analysis that a covered in ore detail in the book.Time to get started!!!OutputCosts

14 Calculating The Break-Even Point in UnitsThe break-even point is calculated from the profit equation when profit is zeroProfit = 0 = Total Revenue - Total Cost0 = Total Revenue-TVC/Unit-TFC= P*Y VC*Y TFCAgain we return to our basic profit and cost model.In this case we set the profit to zero and manipulate the variables until we can solve for Y---the number of units we need to sell to just break-even.Let’s look at what we have in our final equation. The numerator is total fixed costs. It is divided by price minus variable cost. So the numerator is just contribution. If we assume that we devote all of the contribution until we reach the break-even levels of sales to paying off our fixed costs we end up with this equation saying:How many units do we need to sell where each unit contributes X amount to paying fixed costs until all the fixed costs are paid?The contribution from sales above the break-even point is all profit.The derivation of this and all the other break-even extensions can be found in the text.= (P-VC) Y - TFCTFC = (P-VC) YTFC(P-VC)Y == Break-Even Point in Units

15 Calculating The Break-Even Point in DollarsWhere: BEP$= Break-even point in dollarsTFC = Total fixed costsCMP = Contribution Margin PercentageFor example,BEP$ =$750,0000.40BEP$ = $1,875,000 = the Break-Even Point in DollarsTFCCMPBEP$ =The break-even point can also be calculated in dollars as well as units. In this situation you determine the level of contribution per unit as a percentage of the unit selling price---contribution margin percentage. This percentage figure replaces the dollar amount in the denominator in our equation. This gives us a quick way to determine the break-even point in either units or dollar sales.

16 Production CostsThe relationship between the numbers can also be seen in this graph from the text.Here you can see that profits are negative until total revenue is equal to total cost.

17 Meeting Profit as Percentage of Sales Objective Using Break-Even AnalysisTFC(CMP – RPP)BEP$ =RPP = Required Profit PercentageFor example,BEP$ =(0.40 – 0.10)$750,000= $2,500,000(or 20,000 bags at $125 per bag)Here is the fist of a number of extensions of the basic break-even model.In this case we can find what level of sales are need to not break-even but to achieve a specific profit objective.

18 Evaluating Changes in Fixed Costs Using Break Even AnalysisChange in Fixed CostsContribution Margin Percentage=Minimum Changein Dollar Sales Neededto Break-Even forFor example:$1.00This is one of the more important extensions for break-even analysis. Firms are often faced with decisions that involve changing their plant size, putting in processing equipment, or spending money on advertising. This variation is quick way to evaluate the economics of those decisions by establishing the minimum increase in sales needed to pay for such expansions.Let’s work two variations of the equation on the slide. First. Let’s assume the firm is looking to spend $1,000,000 on advertising. How will they know they get their money’s worth? Based on this equation sales would have to rise by $2,500,000 just to pay for the cost of the ads. Managers can use this number to better assess their chances for success.This same approach could be applied to a plant expansion, the investment of $100,000 in a plant expansion would require a minimum sales increase of $250,000 to pay for the investment.Note that in the numerator we can just look at the change in fixed costs---this is just another version of the incremental decision process we have used many time before= $2.50 = minimum increase in dollar sales needed to break-even for each new dollar spent on fixed costs0.40

19 Determining a Selling Price Using Break Even AnalysisSelling Price/Unit = Contribution + Variable Cost/UnitIn this case we are going to rearrange our equation to solve for a selling price for our product that is compatible with our costs and expected sales.

20 Determining a Selling Price Using Break Even AnalysisIf Variable Cost/Unit is known, all needed is ContributionTFCY= ContributionLet’s start by rearranging our basis BEA model to solve for contribution.We can then define the contribution but its two parts (Price – average variable cost) and then solve just for price.

21 Determining a Selling Price Using Break Even AnalysisDetermine contribution by rearranging termsof the break-even equationTFCContribution= YHere is the derivation of the price equation.With this equation mangers know the price of their product that is compatible with this level of sales and costs.These are just some of the most useful applications of break-even analysis. Don’t forget that all this is based on our separation of fixed and variable costs. Be sure to read the text carefully so you get all the deails.____TFC___ = P – VCY____TFC__ + VC = P

22 Inventory Management Reasons to hold inventoryMatching supply with demandPrevent stockoutsLower purchasing costsReasons Not to hold inventoryHigh maintenance costHigh protection costDepreciation and obsolescenceTaxesThe last section of this chapter is devoted to inventory management. Inventory and distribution are two of the hottest areas of business management. MIS and good inventory management systems enable business to closely match sales with production so they can avoid wasteful over production and not miss out on the sales of popular items.

23 Impact of Inventory on ProfitsInventory Value = $100,000Inventory Carrying Cost = $25, (25 percent)Each $1,000 reductionIn Inventory = $250 ProfitsIn Inventory = $5,000 in SalesWe put together this chart to show you the financial impact that good inventory management can have on the business profits.The example cover a fairly typical situation where the cost of having inventory in terms of people to count it, keep it safe, and so on run around 25% of the value of the inventory. If this is perishable items such a flowers or food this number would be higher and benefits of inventory management would be greater.As you can see just a small decrease in inventory can bring sizeable savings to the firm and are equivalent to substantial increases in sales.This is why it pays to keep inventories low!!!Why It Pays to Keep Inventories Low!

24 Basic Inventory Management ModelTotal cost of inventory (TC)Ordering costs sum (OC)Carrying costs (CC)TC = CC + OCMaintaining the proper level of inventory is a two-edged sword. If you maintain a large inventory you will always have the items your customers want. However, a large inventory, as you just saw, is expensive. What we need to do is find a happy middle position that allow us to satisfy both of these objectives.On the next several slides we will lay out the basics of inventory management. If you find these intriguing I can give much more complicated models. For what we are trying to do the basic inventory model will be fine.The total cost of inventories is made up of the costs of ordering items, and the cost of holding (carrying) inventory. The details of the derivation of each of these parts is covered in detail in the text.

25 Managers’ Goal Managers determines Economic Order Quantity (EOQ):Number of items to order each timeMinimizes total costReorder Point (ROP):When to reorder moreStockouts minimizedOur analysis of our inventory has two objectives.First, to determine how much inventory we should order each time we place an order to we can minimize our total cost of inventory. This amount is called the Economic Order Quantity (EOQ). As you can see on the graph on the next slide the EOQ is where the cost of ordering stuff (OC) for inventory is equal to the cost of holding inventory (CC).Our second goal is to know when we need to place an order so we will never run our of anything. This second goal is called the reorder point (ROP).Details on the derivation and calculation of both of these items are in the text.

26 Basic Inventory ModelThis figure from the book gives you a visual view of what the inventory management process is all about.